1、Chapter 20Optimum Currency Areas and the European ExperienceSlide 20-2Copyright 2003 Pearson Education, Inc.Chapter OrganizationHow the European Single Currency EvolvedThe Euro and Economic Policy in the Euro ZoneThe Theory of Optimum Currency AreasThe Future of EMUSummarySlide 20-3Copyright 2003 Pe

2、arson Education, Inc.IntroductionEuropean Union countries have progressively narrowed the fluctuations of their currencies against each other.This culminated in the birth of the euro on January 1, 1999. This chapter focuses on the following questions:How and why did Europe set up its single currency

3、?Will the euro be good for the economies of its members?How will the euro affect countries outside of the European Monetary Union (EMU)?What lessons does the European experience carry for other potential currency blocks?Slide 20-4Copyright 2003 Pearson Education, Inc.IntroductionFigure 20-1: Members

4、 of the Euro Zone as of January 1, 2001Slide 20-5Copyright 2003 Pearson Education, Inc.Table 20-1: A Brief Glossary of EuronymsHow the European Single Currency EvolvedSlide 20-6Copyright 2003 Pearson Education, Inc.How the European Single Currency EvolvedEuropean Currency Reform Initiatives, 1969-19

5、78The Werner report (1969)It set out a blueprint for the stage-by-stage realization of Economic and Monetary Union by proposing a three-phase program to:Eliminate intra-European exchange rate movementsCentralize EU monetary policy decisionsLower remaining trade barriers within Europe Two major reaso

6、ns for adopting the Euro:To enhance Europes role in the world monetary systemTo turn the European Union into a truly unified marketSlide 20-7Copyright 2003 Pearson Education, Inc.The European Monetary System, 1979-1998Germany, the Netherlands, Belgium, Luxemburg, France, Italy, and Britain participa

7、ted in an informal joint float against the dollar known as the “snake.”Most exchange rates could fluctuate up or down by as much as 2.25% relative to an assigned par value.The snake served as a prologue to the more comprehensive European Monetary System (EMS).Eight original participants in the EMSs

8、exchange rate mechanism began operating a formal network of mutually pegged exchange rates in March 1979.How the European Single Currency EvolvedSlide 20-8Copyright 2003 Pearson Education, Inc.Capital controls and frequent realignments were essential ingredients in maintaining the system until the m

9、id-1980s.After the mid-1980s, these controls have been abolished as part of the EUs wider “1992” program of market unification. During the currency crisis that broke out in September 1992, Britain and Italy allowed their currencies to float.In August 1993 most EMS currency bands were widened to 15%

10、in the face of continuing speculative attacks.How the European Single Currency EvolvedSlide 20-9Copyright 2003 Pearson Education, Inc.German Monetary Dominance and the Credibility Theory of the EMSGermany has low inflation and an independent central bank.It also has the reputation for tough anti-inf

11、lation policies.Credibility theory of the EMSBy fixing their currencies to the DM, the other EMS countries in effect imported the German Bundesbanks credibility as an inflation fighter.Inflation rates in EMS countries tended to converge around Germanys generally low inflation rate.How the European S

12、ingle Currency EvolvedSlide 20-10Copyright 2003 Pearson Education, Inc.How the European Single Currency EvolvedFigure 20-2: Inflation Convergence Within Six Original EMS Members, 1978-2000Slide 20-11Copyright 2003 Pearson Education, Inc.The EU “1992” InitiativeThe EU countries have tried to achieve

13、greater internal economic unity by:Fixing mutual exchange ratesDirect measures to encourage the free flow of goods, services, and factors of productionThe process of market unification began when the original EU members formed their customs union in 1957.The Single European Act of 1986 provided for

14、a free movement of people, goods, services, and capital and established many new policies.How the European Single Currency EvolvedSlide 20-12Copyright 2003 Pearson Education, Inc.European Economic and Monetary UnionIn 1989, the Delors report laid the foundations for the single currency, the euro.Eco

15、nomic and monetary union (EMU)A European Union in which national currencies are replaced by a single EU currency managed by a sole central bank that operates on behalf of all EU members.How the European Single Currency EvolvedSlide 20-13Copyright 2003 Pearson Education, Inc.Three stages of the Delor

16、s plan:All EU members were to join the EMS exchange rate mechanism (ERM)Exchange rate margins were to be narrowed and certain macroeconomic policy decisions placed under more centralized EU controlReplacement of national currencies by a single European currency and vesting all monetary policy decisi

17、ons in a ESCBHow the European Single Currency EvolvedSlide 20-14Copyright 2003 Pearson Education, Inc.Maastricht Treaty (1991)It set out a blueprint for the transition process from the EMS fixed exchange rate system to EMU.It specified a set of macroeconomic convergence criteria that EU countries ne

18、ed to satisfy for admission to EMU.It included steps toward harmonizing social policy within the EU and toward centralizing foreign and defense policy decision.How the European Single Currency EvolvedSlide 20-15Copyright 2003 Pearson Education, Inc.EU countries moved away from the EMS and toward the

19、 single shared currency for four reasons:Greater degree of European market integrationSame opportunity as Germany to participate in system-wide monetary decisionsComplete freedom of capital movementsPolitical stability of EuropeHow the European Single Currency EvolvedSlide 20-16Copyright 2003 Pearso

20、n Education, Inc.The Euro and Economic Policy in the Euro ZoneThe Maastricht Convergence Criteria and the Stability and Growth PactThe Maastricht Treaty specifies that EU member countries must satisfy several convergence criteria:Price stabilityMaximum inflation rate 1.5% above the average of the th

21、ree EU member states with lowest inflationExchange rate stabilityStable exchange rate within the ERM without devaluing on its own initiativeBudget disciplineMaximum public-sector deficit 3% of the countrys GDPMaximum public debt 60% of the countrys GDPSlide 20-17Copyright 2003 Pearson Education, Inc

22、.The Euro and Economic Policy in the Euro Zone Figure 20-3: Behavior of the Euros Exchange Rates Against Major CurrenciesSlide 20-18Copyright 2003 Pearson Education, Inc.A Stability and Growth Pact (SGP) in 1997 sets up:The medium-term budgetary objective of positions close to balance or in surplusA

23、 timetable for the imposition of financial penalties on counties that fail to correct situations of “excessive” deficits and debt promptly enoughThe Euro and Economic Policy in the Euro ZoneSlide 20-19Copyright 2003 Pearson Education, Inc.The European System of Central BanksIt consists of the Europe

24、an Central Bank in Frankfurt plus 12 national central banks.It conducts monetary policy for the euro zone.It is dependent on politicians in two respects:The ESCBs members are political appointments.The Maastricht Treaty leaves exchange rate policy for the euro zone ultimately in the hands of the pol

25、itical authorities.The Euro and Economic Policy in the Euro ZoneSlide 20-20Copyright 2003 Pearson Education, Inc.The Revised Exchange Rate MechanismIt defines broad exchange rate zones for EU countries that are not yet members of EMU against the euro. It specifies reciprocal intervention arrangement

26、s to support these target zones.It is referred to as ERM 2.It was viewed necessary in order to: Discourage competitive devaluations against the euro by EU members outside the euro zoneGive would-be EMU entrants a way of satisfying the exchange rate stability convergence criterionThe Euro and Economi

27、c Policy in the Euro ZoneSlide 20-21Copyright 2003 Pearson Education, Inc.The Theory of Optimum Currency AreasTheory of optimum currency areasIt predicts that fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements.Slide 20-22Copyright

28、2003 Pearson Education, Inc.Economic Integration and the Benefits of a Fixed Exchange Rate Area: GG ScheduleMonetary efficiency gainThe joiners saving from avoiding the uncertainty, confusion, and calculation and transaction costs that arise when exchange rates float. It is higher, the higher the de

29、gree of economic integration between the joining country and the fixed exchange rate area.GG scheduleIt shows how the potential gain of a country from joining the euro zone depends on its trading link with that region.It slopes upward.The Theory of Optimum Currency AreasSlide 20-23Copyright 2003 Pea

30、rson Education, Inc.The Theory of Optimum Currency AreasFigure 20-4: The GG ScheduleDegree of economic integration between the joining country and the exchange rate area Monetary efficiency gain for the joining countryGGSlide 20-24Copyright 2003 Pearson Education, Inc.Economic Integration and the Co

31、sts of a Fixed Exchange Rate Area: The LL ScheduleEconomic stability lossThe economic stability loss that arises because a country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment.It is lower, the

32、higher the degree of economic integration between a country and the fixed exchange rate area that it joins.LL scheduleIt shows the relationship of the countrys economic stability loss from joining.It slopes downward.The Theory of Optimum Currency AreasSlide 20-25Copyright 2003 Pearson Education, Inc

33、.The Theory of Optimum Currency AreasFigure 20-5: The LL ScheduleDegree of economic integration between the joining country and the exchange rate areaEconomic stabilityloss for the joining countryLLSlide 20-26Copyright 2003 Pearson Education, Inc.The Decision to Join a Currency Area: Putting the GG

34、and LL Schedules TogetherThe intersection of GG and LL Determines a critical level of economic integration between a fixed exchange rate area and a countryShows how a country should decide whether to fix its currencys exchange rate against the euroThe Theory of Optimum Currency AreasSlide 20-27Copyr

35、ight 2003 Pearson Education, Inc.The Theory of Optimum Currency AreasFigure 20-6: Deciding When to Peg the Exchange RateDegree of economic integrationbetween the joining country andthe exchange rate areaGains and lossesfor the joining countryLLGGGains exceedlossesLosses exceedgains11Slide 20-28Copyr

36、ight 2003 Pearson Education, Inc.The GG-LL framework can be used to examine how changes in a countrys economic environment affect its willingness to peg its currency to an outside currency area.Figure 20-7 illustrates an increase in the size and frequency of sudden shifts in the demand for the count

37、rys exports.The Theory of Optimum Currency AreasSlide 20-29Copyright 2003 Pearson Education, Inc.The Theory of Optimum Currency AreasFigure 20-7: An Increase in Output Market VariabilityLL1GGLL222Degree of economic integrationbetween the joining country andthe exchange rate areaGains and lossesfor t

38、he joining country11Slide 20-30Copyright 2003 Pearson Education, Inc.What Is an Optimum Currency Area?It is a region where it is best (optimal) to have a single currency.Optimality depends on degree of economic integration:Trade in goods and servicesFactor mobilityA fixed exchange rate area will bes

39、t serve the economic interests of each of its members if the degree of output and factor trade among them is high.The Theory of Optimum Currency AreasSlide 20-31Copyright 2003 Pearson Education, Inc.The Theory of Optimum Currency AreasFigure 20-8: Intra-EU Trade as a Percent of EU GDPSlide 20-32Copy

40、right 2003 Pearson Education, Inc.The Theory of Optimum Currency AreasTable 20-2: People Changing Region of Residence in 1986 (percent of total population)Slide 20-33Copyright 2003 Pearson Education, Inc.Case Study: Is Europe an Optimum Currency Area?Europe is not an optimum currency area:Most EU co

41、untries export form 10% to 20% of their output to other EU countries.EU-U.S. trade is only 2% of U.S. GNP.Labor is much more mobile within the U.S. than within Europe.Federal transfers and changes in federal tax payments provide a much bigger cushion for region-specific shocks in the U.S. than do EU revenues and expenditures.The Theory of Optimum Currency AreasSlide 20-34Copyright 2003 Pearson Education,